All you need to know about bonds

As regards diversification in a portfolio we like to have an element of fixed interest paying obligations (bonds). There are various types of bonds in which to invest from those bonds issued by companies (Corporate bonds) through to bonds issued by governments (Gilts in the case of the UK).

The main point of bonds from our point of view is to provide diversification for an investment portfolio (an asset which may perform differently to equities). For UK investors we currently favour investing in UK government bonds (Gilts) as opposed to corporate bonds because of the risk/reward characteristics; gilts have the great advantage that, absent a general collapse of the financial system, the UK government will honour its debt and repay the face value of the gilt at its maturity.

In a deflationary environment, for example, gilts are one of the few asset classes which should perform well.

Why invest in bonds?

We use bonds to provide a liquid source of diversification for our asset allocation that is below the risk of equities but that should offer a higher return than cash.

Bond selection process

Choosing among bonds is about credit assessment (the chance of not being repaid), duration (the average time until the cash flows from the bonds arrive) and the market interest rate.

Since we are using bonds for low risk diversification, we are biased towards investing in UK Government debt (for UK investors) as opposed to corporate debt, particularly if we already have a bias to equities (ie. corporate debt and equities share at least some of the same risks). Generally, we will want to invest in bonds that have a chance of being inversely correlated with the performance of equities.

Our bond selection process entails:

• Consideration of the value in the ten year gilt yield versus equities;
• Redemption yields versus current interest rates;
• Maturity profile.